Common ESOP Use Cases

Employee stock ownership plans are industry-agnostic and adaptable enough to meet a range of stakeholder objectives. 

Most US-based companies with at least three years of continuous operations are permitted to form a plan. Firms with adjusted EBITDAs over $3 million may be better equipped to manage the expenses and reap the full benefits of a leveraged ESOP. That isn’t a hard and fast rule, though. Several factors influence the cost-benefit analysis underlying an employee ownership strategy. 

Beyond those statutory requirements and general guidelines, a variety of scenarios and unique goals often drive ESOP consideration.

Top ESOP Use Cases and Potential "Good Fits"

Shareholders Taking "Chips off the Table"

Founders and owners often have most of their net worth locked up in their companies. At the same time, many have no intention of selling out and walking away. Whether they’re too young for retirement, want their firms to remain independent, or enjoy their current work-life balance, a third-party sale is generally not an option.

Partial ESOP sales offer a meaningful compromise. When shareholders sell a minority stake to an employee trust, they can receive fair market value for their shares, maintain future upside potential, and continue with their day-to-day routine and responsibilities. Furthermore, when at least 30% of outstanding equity is sold to an ESOP, a selling shareholder can defer capital gains taxes on their proceeds.

Following the transaction, an employee-owned company is free to sell additional shares to the ESOP, repurchase stock, make acquisitions, or sell to outside buyers. That represents significant flexibility for owners with extended time horizons. 

Family Business Succession Alternative

Intergenerational transfers have become a rarity. Many family businesses would prefer to remain independent, but younger family members increasingly forge their own career paths, and internal equity sales can carry significant tax burdens. Departing shareholders often need liquidity, so gifting isn’t always a solution.

A leveraged ESOP buyout of individual owners or entire ownership groups can help perpetuate a family-owned company’s legacy and set the stage for additional, targeted ownership transfers. How so? The seller note and/or third-party debt that helps facilitate these transactions will temporarily depress a company’s value. Shareholders can use that opportunity to gift retained interest without triggering taxable limits or sell outstanding equity or warrants to family members at lower valuations.

The liquidity generated by an ESOP sale enables families to financially prepare for looming estate tax burdens without having to engage in the forced sale of a closely held business. As a result, this unique version of shared ownership enables businesses to stay in families, prepare for the future, and remain rooted in their communities. 

Facilitate a Management Buyout

Willing and able management teams often don’t have the financial wherewithal to orchestrate shareholder buyouts. Cash is usually tight, and it’s challenging to raise transaction financing independently. Even in instances where a standard management buyout (MBO) is feasible, the unfavorable tax treatment on both sides of the deal can cloud a transaction.

When leveraged ESOP-MBOs are structured, the sponsoring company can negotiate the creation of warrants alongside the sale of stock to an employee stock ownership trust. Like stock options, warrants are a form of synthetic equity that grants holders the right to purchase company shares for a specified period at a predetermined price. This strike price is typically low, as it reflects the business’s depressed valuation post-transaction.

Selling shareholders are permitted to gift or sell warrants to their management team. This enables a management team to take a meaningful stake in the company, beyond standard ESOP allocations. Warrants can appreciate as the company delivers and grows, driving real economic value to the company’s new leaders. 

High Payroll Companies

A leveraged ESOP sale creates corporate income tax deductions equivalent to the transaction price. For example, a $10 million stock sale can result in $10 million in write-offs for the sponsoring company. However, the pace at which those deductions are utilized is tied to a company’s payroll. That puts staffing, professional services, and other labor-intensive firms in a unique position.

An employee-owned business earns a portion of its allotted deductions when the firm makes contributions to its ESOP plan. Contributions are limited to 25% of the company’s annual ESOP-eligible payroll. So, if the firm in question has an $8 million annual W-2 payroll, it can make a $2 million non-cash contribution to the plan and earn $2 million in annual deductions. In other words, the higher the payroll, the faster a company can utilize its overall tax benefits. 

Asset-Heavy Companies

Latent tax liabilities can significantly impact the sale of a trucking, real estate, or equipment-intensive company to a third party. Asset-heavy firms typically utilize accelerated depreciation to lower their annual income tax burdens. In a typical asset sale, the difference between the market value and the depreciated cost of these assets is taxed at ordinary income rates. This is known as depreciation recapture.

An ESOP deal is a stock sale, not an asset sale. As a result, a properly crafted transaction will not trigger depreciation recapture. That can meaningfully enhance a selling shareholder’s post-tax sale proceeds.

Government Contractors and Other Designated Businesses

When GovCon and related minority, veteran, and woman-owned firms consider M&A options, two issues commonly arise:  the buyer pool is often limited, and strategic sales may result in the loss of a valuable set-aside status. These constraints can negatively impact a company’s sale value if a transaction can be consummated at all.

Minority ESOP sales and even some majority transactions can be structured to help contractors preserve their status and secure fair market shareholder liquidity events. Furthermore, employee-owned, cost-plus vendors can benefit from an added incentive. ESOP contributions and dividends represent "allowable" expenses and are reimbursed by the government on cost-plus contracts.

Various Intangibles also Drive Employee Ownership Decisions

Unlike most M&A transactions, employee stock ownership plans offer potential benefits that go beyond a standard liquidity event. For many private and family-owned companies, it's challenging to pass up the opportunity to positively impact employees' lives and establish a lasting business legacy. An ESOP can represent the ultimate "thank you" to a workforce and a broader community that helped a company rise and flourish.